This blog aims to study the mechanics of business and occasionally find a gem of insight.

(Consult your financial adviser before making investment decisions. Following the advice here does not guarantee performance and there is a substantial risk of loss)

Tuesday, April 20, 2010

Interest Rate Parity Condition

The Interest Rate Parity condition that is in the CFA and discussed in our Global Managerial Perspective (GMP) class talks about.

Long story short, it says: Regardless of what financial mechanisms are used, two countries which are considered to be default free should generate the same real returns for the same period.

For example:Today:

You hold $1 USD

The FX rate is 100 yen per USD

The Japanse Bonds are yielding 5%

A year from now:

FX rate is expected to be 103 yen per USD

What does IRP imply the interest rate on the US bond should be?

This can be graphically represented by:

The blue path shows how $1 USD is convered to Japanese Yen, held in a bond, and converted back at the new exchange rate back into USD. IRP states that whether this route is taken or if the USD is just held in a US bond (Red path) should make no difference. It should result in the same amount otherwise there is an arbitrage opportunity.

This is the solution. Note that the US bond rate is reverse engineered from the information given such that the end result produced in the red path is the same as the blue path.

You also note that there is a relationship which is defined by IRP. That is: